ALL POSTS PRIOR TO 2021 HAVE NOT BEEN REVIEWED NOR APPROVED BY ANY FIRM OR INSTITUTION, AND REFLECT ONLY THE PERSONAL VIEWS OF THE AUTHOR.
Part 8 (Last in a Series) on the Regulation of Financial and Investment Advice:
Examining the Fiduciary Duties of Investment Advisers Under State Common Law
In 2018 the SEC published a draft of its interpretation of the fiduciary duties of investment advisers. Yet, in that draft they omitted several requirements - particularly in reference to the fiduciary duty of loyalty and what is required when a conflict of interest exist. The SEC's draft could lead investment advisers to believe their conduct is "o.k." - when in fact litigation (and arbitration) occurs as a result of state common law fiduciary claims - and only very rarely under the Advisers Act itself (as, generally, there is no private right of action under the Advisers Act).
Herein I set forth - in detail (no surprise there!) - the fiduciary duties of investment advisers, as discerned from both the SEC's proposed rule, but as augmented with state common law understandings of the fiduciary standard of conduct. Remember - the SEC sets the floor - not the ceiling. Advisers should conform their conduct to the higher standard. (And, when ERISA applies, even higher standards may be required - which are not set forth hereunder.)
Not all securities lawyers will agree with the elicitation of fiduciary standards I set forth below. In part, in my view, this is because of a (wishful) misinterpretation of SEC vs. Capital Gains Research Bureau, which I have previously written about. And this is due in part to a lack of realization of the limited role of waiver and estoppel in fiduciary relationships of this type. Debates will continue, no doubt, with dual registrant firms and their attorneys arguing for a weaker interpretation of the fiduciary standard, while others (such as myself) see the fiduciary standard as one that should not be weakened nor subject to "particular exceptions" (as the late Justice Benjamin Cardozo would have put it.)
This elicitation remains a work-in-progress. Much additional legal research can be undertaken to locate and provide additional authority for the propositions taken herein.
A FURTHER ELICITATION OF STATE COMMON LAW
FIDUCIARY STANDARDS OF CONDUCT, WHICH SHOULD GOVERN
THE DELIVERY OF INVESTMENT ADVICE
(Derived in part from the SEC’s proposed interpretation, but
supplemented and corrected with my own language and recitations to authority)
An investment adviser is a fiduciary, and as such is held to the highest standard of conduct and must act in the best interest of its client.Its fiduciary obligation, which includes an affirmative duty of utmost good faith and full and fair disclosure of all material facts, is established under various federal laws and state common law and is important to the Commission’s investor protection efforts.The Commission also regulates broker-dealers, including the obligations that broker-dealers owe to their customers. Investment advisers and broker-dealers provide advice and services to retail investors and are important to our capital markets and our economy more broadly. Broker-dealers and investment advisers may have different types of relationships with their customers and clients and have different models for providing advice, which provide investors with choice about the nature and extentof advice they receive and how they pay for the services or products that they receive.
The Advisers Act establishes a federal fiduciary standard for investment advisers.This fiduciary standard is based on equitable common law principles and is fundamental to advisers’ relationships with their clients under the Advisers Act.The fiduciary duty to which advisers are subject is not specifically defined in the Advisers Act or in Commission rules, but reflects a Congressional recognition “of the delicate fiduciary nature of an investment advisory relationship” as well as a Congressional intent to “eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser – consciously or unconsciously – to render advice which was not disinterested.”An adviser’s fiduciary duty is imposed under the Advisers Act in recognition of the nature of the relationship between an investment adviser and a client and the desire “so far as is presently practicable to eliminate the abuses” that led to the enactment of the Advisers Act.It is made enforceable by the antifraud provisions of the Advisers Act.Investment advisers also possess broad fiduciary duties arising under state common law, which is enforceable primarily through civil action brought against the investment adviser by the adviser’s client.
An investment adviser’s fiduciary duty under the Advisers Act comprises a duty of due care and a duty of loyalty,although other duties may be surmised. Several commenters responding to Chairman Clayton’s June 2017 request for public inputon the standards of conduct for investment advisers and broker-dealers acknowledged these duties.
This fiduciary duty requires an adviser “to adopt the principal’s goals, objectives, or ends.”
This means the adviser must, at all times, serve the best interest of its clients and not subordinate its clients’ interest to its own.
The federal fiduciary duty is imposed through the antifraud provisions of the Advisers Act. The duty follows the contours of the relationship between the adviser and its client, and the adviser and its client may shape that relationship through contract when the client receives full and fair disclosure and provides informed consent,and further provided the transaction is substantively fair to the client. Although the ability to tailor the terms means that the application of the fiduciary duty will vary with the terms of the relationship, the relationship in all cases remains that of a fiduciary to a client. In other words, the investment adviser cannot disclose or negotiate away, and the investor cannot waive, the fiduciary duty.
A. Duty of Due Care
As fiduciaries, investment advisers owe their clients a duty of due care.
The Commission has discussed the duty of care and its components in a number of contexts.The duty of care includes, among other things: (i) the duty to act and to provide advice that is in the best interestof the client, (ii) the duty to seek best execution of a client’s transactions where the adviser has the responsibility to select broker-dealers to execute client trades, and (iii) the duty to provide advice and monitoring over the course of the relationship.
1. Duty to Provide Advice With the Requisite Degree of Required Expertise, Due Diligence, and Skill.
The SEC has previously addressed an adviser’s duty of care in the context of the provision of personalized investment advice. In this context, the duty of care includes a duty to make a reasonable inquiry into a client’s financial situation, level of financial sophistication, investment experience, and investment objectives (which is referred to collectively as the client’s “investment profile”) and a duty to provide personalized advice that is suitablefor and in the best interestof the client based on the client’s investment profile.
An adviser must, before providing any personalized investment advice and as appropriate thereafter, make a reasonable inquiry into the client’s investment profile. The nature and extent of the inquiry turn on what is reasonable under the circumstances, including the nature and extent of the agreed-upon advisory services, the nature and complexity of the anticipated investment advice, and the investment profile of the client. For example, to formulate a comprehensive financial plan for a client, an adviser might obtain a range of personal and financial information about the client, including current income, investments, assets and debts, marital status, insurance policies, and financial goals.
An adviser must update a client’s investment profile in order to adjust its advice to reflect any changed circumstances. The frequency with which the adviser must update the information in order to consider changes to any advice the adviser provides would turn on many factors, including whether the adviser is aware of events that have occurred that could render inaccurate or incomplete the investment profile on which it currently bases its advice. For example, a change in the relevant tax law or knowledge that the client has retired or experienced a change in marital status might trigger an obligation to make a new inquiry.
An investment adviser must also have a reasonable belief that the personalized advice is suitable for the client based on the client’s investment profile. A reasonable belief would involve considering, for example, whether investments are recommended only to those clients who can and are willing to tolerate the risks of those investments and for whom the potential benefits may justify the risks.Whether the advice is proper must be evaluated in the context of the portfolio that the adviser manages for the client and the client’s investment profile.
The cost (including fees and compensation) associated with investment advice and the recommended investmentsis generally be one of many important factors – such as the investment product’s or strategy’s investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions – to consider when determining whether a security or investment strategy involving a security or securities is in the best interestof the client. Accordingly, the fiduciary duty does not necessarily require an adviser to recommend the lowest cost investment product or strategy.The SEC has stated that an adviser could not reasonably believe that a recommended security is in the best interest of a client if it is higher cost than a security that is otherwise identical, including any special or unusual features, liquidity, risks and potential benefits, volatility and likely performance.Furthermore, an adviser would not satisfy its fiduciary duty to provide advice that is in the client’s best interest by simply advising its client to invest in the least expensive or least remunerative investment product or strategy without any further analysis of other factors in the context of the portfolio that the adviser manages for the client and the client’s investment profile. A reasonable belief that investment advice is in the best interest of a client also requires that an adviser conduct a reasonable investigationinto the investment sufficient to not base its advice on materially inaccurate or incomplete information.The Sec has brought enforcement actions where an investment adviser did not independently or reasonably investigate securities before recommending them to clients.This obligation to provide advice that is suitable and in the best interest applies not just to potential investments, but to all advice the investment adviser provides to clients, including advice about an investment strategy or engaging a sub-adviser and advice about whether to rollover a retirement account so that the investment adviser manages that account.
Assessment of an investment adviser’s exercise of due care is undertaken by assessing both process and substance. In reviewing the conduct of an investment adviser in adherence to the investment adviser’s fiduciary duty of due care, the review would likely involve an analysis as to whether the decision made by the investment adviser was informed (procedural due care). The very word “care” connotes a process. Procedural due care is often met through the application of an appropriate decision-making process, and judged under the standard, not (necessarily) by the end result. But it is not enough to just possess a process; the steps in the process cannot be constructed nor implemented recklessly; the exercise of sound judgment must occur during the creation of the process and then as each step of the process is undertaken.
A review of an investment adviser’s exercise of due care also includes an assessment of the substance of the transaction or advice given (substantive due care).
In assessing the due care undertaken by the investment adviser, the investment adviser is judged as an expert, as the standard of due care is relational.Industry association standards are often highly probative when further defining the standard of care.
2. Duty to Seek Best Execution
The SEC addressed an investment adviser’s duty of care in the context of trade execution where the adviser has the responsibility to select broker-dealers to execute client trades (typically in the case of discretionary accounts). The SEC has stated that, in this context, an adviser has the duty to seek best execution of a client’s transactions.In meeting this obligation, an adviser must seek to obtain the execution of transactions for each of its clients such that the client’s total cost or proceeds in each transaction are the most favorable under the circumstances. An adviser fulfills this duty by executing securities transactions on behalf of a client with the goal of maximizing value for the client under the particular circumstances occurring at the time of the transaction. Maximizing value can encompass more than just minimizing cost. When seeking best execution, an adviser should consider “the full range and quality of a broker’s services in placing brokerage including, among other things, the value of research provided as well as execution capability, commission rate, financial responsibility, and responsiveness” to the adviser. The determinative factor is not the lowest possible commission cost but whether the transaction represents the best qualitative execution. Further, an investment adviser should “periodically and systematically” evaluate the execution it is receiving for clients.
The Advisers Act does not prohibit advisers from using an affiliated broker to execute client trades. However, the adviser’s use of such an affiliate involves a conflict of interest that must be fully and fairly disclosed and the client must provide informed consent to the conflict. Even then, the use of the affiliated broker should be substantively fair to the client.
3. Duty to Act and to Provide Advice and Monitoring over the Course of the Relationship
An investment adviser’s duty of care also encompasses the duty to provide advice and monitoring over the course of a relationship with a client.An adviser is required to provide advice and services to a client over the course of the relationship at a frequency that is both in the best interest of the client and consistent with the scope of advisory services agreed upon between the investment adviser and the client. The duty to provide advice and monitoring is particularly important for an adviser that has an ongoing relationship with a client (for example, a relationship where the adviser is compensated with a periodic asset-based fee or an adviser with discretionary authority over client assets). Conversely, the steps needed to fulfill this duty may be relatively circumscribed for the adviser and client that have agreed to a relationship of limited duration via contract (for example, a financial planning relationship where the adviser is compensated with a fixed, one-time fee commensurate with the discrete, limited-duration nature of the advice provided).
An adviser’s duty to monitor extends to all personalized advice it provides the client, including an evaluation of whether a client’s account or program type (for example, a wrap account) continues to be in the client’s best interest.
B. Duty of Loyalty
(1) Generally.
The duty of loyalty, the most distinctive of the duties imposed upon a fiduciary,requires an investment adviser to put its client’s interests first.
Under the fiduciary duty of loyalty, as developed over centuries of case law, there is a duty to not possess a conflict of interest, and also a duty to not profit off of the client.In other words, fiduciaries owe the obligation to their client to not be in a position where there is a substantial possibility of conflict between self-interest and duty.[37]This is called the “no-conflict” rule, derived from English law. Fiduciaries also possess the obligation not to derive unauthorized profits from the fiduciary position. This is called the “no profit” rule, also derived from English law.[38]
Because an adviser must serve the best interests of its clients, it has an obligation not to subordinate its clients’ interests to its own.
(2) Examples of Non-Subordination of Interests: Trade Allocations; Favoring Higher-Fee Clients.
For example, an adviser cannot favor its own interests over those of a client, whether by favoring its own accounts or by favoring certain client accounts that pay higher fee rates to the adviser over other client accounts.
(3) Not Preferring the Interests of One Client Over Another.
An investment adviser must not favor its own interests over those of a clientor unfairly favor one client over another.
Accordingly, the duty of loyalty includes a duty not to treat some clients favorably at the expense of other clients. Thus, in allocating investment opportunities among eligible clients, an adviser must treat all clients fairly.This does not mean that an adviser must have a pro rata allocation policy, that the adviser’s allocation policies cannot reflect the differences in clients’ objectives or investment profiles, or that the adviser cannot exercise judgment in allocating investment opportunities among eligible clients. Rather, it means that an adviser’s allocation policies must be fair and, if they present a conflict, the adviser must fully and fairly disclose the conflict such that a client can provide informed consent.
(1) The Necessity to Seek to Avoid Conflicts of Interest.
An adviser must seek to avoid conflicts of interest with its clients.
The “no-conflict rule” states, in essence, that fiduciaries owe the obligation to their client to not be in a position where there is a substantial possibility of conflict between self-interest and duty.
The no-conflict rule is firmly embedded in the federal fiduciary standard. In SEC vs. Capital Gainsthe U.S. Supreme Court explained the no conflict rule and provided the rationale behind the prohibition on serving two masters:
This Court, in discussing conflicts of interest, has said: ‘The reason of the rule inhibiting a party who occupies confidential and fiduciary relations toward another from assuming antagonistic positions to his principal in matters involving the subject matter of the trust is sometimes said to rest in a sound public policy, but it also is justified in a recognition of theauthoritative declaration that no man can serve two masters; and considering that human nature must be dealt with, the rule does not stop with actual violations of such trust relations, but includes within its purpose the removal of any temptation to violate them .... In Hazelton v. Sheckells, 202 U.S. 71, 79, we said: ‘The objection . . . rests in their tendency, not in what was done in the particular case … The court will not inquire what was done. If that should be improper it probably would be hidden and would not appear.’
In an ideal world, no conflicts of interest between an adviser and its clients would ever exist. Indeed, the avoidance of conflicts of interest was a principal reason behind the enactment of the Advisers Act:
The IAA arose from a consensus between industry and the SEC that ‘investment advisers could not 'completely perform their basic function — furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments — unless all conflicts of interest between the investment counsel and the client were removed.'
It should again be noted that when an adviser is a fiduciary under ERISA, conflicts of interest must generally be avoided,absent a class or other exemption from the prohibited transaction rules.
However, while avoidance of a conflict of interest is the best method to adhere to an investment adviser’s fiduciary duty of loyalty,and even other securities laws or regulations require the avoidance of certain conflicts of interest (even in non-fiduciary relationships),it must be acknowledged that not all conflicts of interest can be avoided. In this regard, the “best interests” fiduciary standard is not as strict as the “sole interests” fiduciary standard applicable under the trust law of many states (and under ERISA), in that conflicts of interest may exist at times. However, even when a conflict of interest exists, actions must be taken to ensure that the client is not harmed. In other words, the conflict of interest, even when affirmatively and fully disclosed, must be properly managed through a process that includes obtaining the client’s informed consentand, even then, that the transaction remains substantively fair to the client.
In the large financial services firm of today, there exists multiple areas where conflicts of interest might arise. As a result, at least one commentator has incorrectly interpreted the SEC vs. Capital Gains decision as a “pragmatic recognition by the Court of the complexities of the operations of contemporary investment advisers.”But, the fiduciary standard of conduct should be lessened in order to adapt to the functions of the marketplace; rather, the marketplace should conform to the fiduciary standard of conduct. Indeed, the fiduciary duty of loyalty is not abrogated merely because of the size or nature of the firm or its diverse activities. “The standard of conduct required of the fiduciary is not diminished by reason of its organizational structure.”
(2) Procedures to Follow When a Conflict of Interest is Still Present.
Should a conflict of interest exist, the law provides for a multi-stage processdesigned to ensure that the client’s best interests are not subordinated to those of the adviser.
(A) STEP ONE: Affirmative Disclosure of the Conflict of Interest, All Material Facts Relating Thereto, and the Ramifications to the Client.
Disclosure of a conflict alone is not alwayssufficient to satisfy the adviser’s duty of loyalty and section 206 of the Advisers Act.However, disclosure of a conflict of interest is one part of a multi-stage process which, if effectively followed by an investment adviser, may result in a defense to the breach of the fiduciary duty of loyalty that arises from the existence of a conflict of interest.
The disclosure of the conflict of interest, and material facts concerning same, must be specific to that conflict of interest. Communications that generallydisclose existing or potential conflicts of interest fail to provide clients with an appreciation of all material facts and are generally ineffective as a basis for a client’s informed consent.
The disclosure must be timely given. “[D]isclosure, if it is to be meaningful and effective, must be timely. It must be provided before the completion of the transaction so that the client will know all the facts at the timethat he is asked to give his consent.”
Disclosure must be affirmatively undertaken.The duty to disclose is an affirmative one and rests with the advisor alone.As conveyed by a recent statement of SEC Staff, clients do not generally possess a duty of inquiry in such circumstances: “The [Commission] Staff believes that it is the firm’s responsibility—not the customers’ — to reasonably ensure that any material conflicts of interest are fully, fairly and clearly disclosed so that investors may fully understand them.”
The fiduciary is required to ensure that the disclosure is received by the client; the “access equals delivery” approach adopted by the Commission in connection with the delivery of a full prospectus to a consumerwould not likely qualify as an appropriate disclosure by a fiduciary investment adviser to her or his client of material facts.
Actual disclosure must occur, rather than readiness to disclose.Constructive knowledge of the conflict of interest by the client is insufficient.
Disclosure must be sufficient to obtain client understanding. The fiduciary must be aware of the client’s capacity to understand, and match the extent and form of the disclosure to the client’s knowledge base and cognitive abilities.
As stated in an early decision by the SEC:
[We] may point out that no hard and fast rule can be set down as to an appropriate method for registrant to disclose the fact that she proposes to deal on her own account. The method and extent of disclosure depends upon the particular client involved. The investor who is not familiar with the practices of the securities business requires a more extensive explanation than the informed investor. The explanation must be such, however, that the particular client is clearly advised andunderstandsbefore the completion of each transaction that registrant proposes to sell her own securities.” [Emphasis added.]
The disclosure must not be combined with attempts to unduly influence or coerce the client. Informed consent cannot be obtained through coercion nor sales pressure.
Any disclosure must be clear and detailed enough for a client to make a reasonably informed decision to provide informed consent to such conflicts and practices or reject them.
An adviser must provide the client with sufficiently specific facts so that the client is able to understand the adviser’s conflicts of interest and business practices well enough to make an informed decision.The ramifications of the conflict of interest must be disclosed, so that the client understands the significance of the conflict of interest as it bears upon the client’s affairs.
The disclosure must be frank. As stated by Justice Benjamin Cardoza: “If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity of reservation, in all its stark significance ….”
The disclosure must be fulland forthright. Even reasonably anticipated conflicts of interest must be disclosed.However, an adviser disclosing that it “may” have a conflict is not adequate disclosure when the conflict actually exists.
(B) STEP TWO: Understanding by the Client, and the Client’s Grant of Informed Consent.
Following receipt of the disclosures provided, the client must achieve an understanding of the conflict of interest and its ramifications to the client, as well as an understanding of material facts disclosed. With such understanding, the client must then provide informed consent.
Early on the U.S. Securities and Exchange Commission, and the courts, acknowledged that in applying the fiduciary requirements of the Advisers Act a client must provide informed consent.Informed consent provides the client with the opportunity, should the client so choose, to waive the conflict of interestIf a conflict of interest is not avoided and does exist in a fiduciary relationship,mere disclosure to the client of the conflict, followed by mere consent by a client to the breach of the fiduciary obligation, does not suffice.
A client’s informed consent can be either explicit or, depending on the facts and circumstances, implicit. However, it is not consistent with an adviser’s fiduciary duty to infer or accept client consent to a conflict where either (i) the facts and circumstances indicate that the client did not understand the nature and import of the conflict, or (ii) the material facts concerning the conflict could not be fully and fairly disclosed.
For example, in some cases, conflicts may be of a nature and extent that it would be difficult to provide disclosure that adequately conveys the material facts or the nature, magnitude and potential effect of the conflict necessary to obtain informed consent and satisfy an adviser’s fiduciary duty. In other cases, disclosure may not be specific enough for clients to understand whether and how the conflict will affect the advice they receive. With some complex or extensive conflicts, it may be difficult to provide disclosure that is sufficiently specific, but also understandable, to the adviser’s clients. In all of these cases where full and fair disclosure and informed consent is insufficient, the adviser to eliminate the conflict or adequately mitigate the conflict so that it can be more readily disclosed.
Assuming full, frank and affirmative disclosure of a conflict of interest and its ramifications for the client, and assuming the client provides full consent, only provides a limited defense for the fiduciary against breach of fiduciary duty if the proposed transaction is also substantively fair to the client, as will be discussed in the next section. In other words, disclosure and informed consent do not terminate the fiduciary character of the relationship. Rather, the fiduciary remains subject to fiduciary duties and remains obligated to act loyally and with due care.
(C) STEP THREE: THE PROPOSED TRANSACTION MUST BE AND REMAIN SUBSTANTIVELY FAIR TO THE CLIENT
Even if the procedural safeguards of full, complete and affirmative disclosure leading to client understanding and to the client’s grant of informed consent all occur, a remaining mandatory substantive requirement exists– that the fiduciary deal fairly with the client.This is because no client would be presumed to authorize a fiduciary to act in bad faith.As stated by one court:
One of the most stringent precepts in the law is that a fiduciary shall not engage in self-dealing and when he is so charged, his actions will be scrutinized most carefully. When a fiduciary engages in self-dealing, there is inevitably a conflict of interest: as fiduciary he is bound to secure the greatest advantage for the beneficiaries; yet to do so might work to his personal disadvantage. Because of the conflict inherent in such transaction, it is voidable by the beneficiaries unless they have consented. Even then, it is voidable if the fiduciary fails to disclose material facts which he knew or should have known, if he used the influence of his position to induce the consent orif the transaction was not in all respects fair and reasonable.
(4) Understanding the Distinction: The “Best Interests” vs. “Sole Interests” Fiduciary Standards.
The fiduciary standard of conduct is a tough standard, often called “the highest standard under the law.” How the fiduciary standard of conduct is applied (when it is found to exist) is surprisingly uniform. Yet, distinctions do exist in some contexts, such as between the regulatory regimes of state common law and the Advisers Act (applying a “best interests” fiduciary standard) and the regulatory regime of ERISA (applying, generally, a “sole interests” fiduciary standard, enhanced with prohibited transaction restrictions, as modified through class or other exemptions).
The Advisers’ Act fiduciary standard of conduct is generally described as a “best interests” fiduciary standard of conduct. The Advisers Act has always adopted the “best interests” standard as a codification of state common law applicable to relationships based upon trust and confidence.
In contrast, the “sole interests” standard of conduct found in trust law and (with some modification) under ERISA, is generally believed to be somewhat stricter, particularly with regard to the fiduciary’s obligations with respect to conflicts of interest. Generally, under state common law in which a “sole interests” standard is applied (generally, in trustee-beneficiary relationships), any form of self-dealing is essentially prohibited. [ERISA therefore has stricter prohibitions against self-dealing, and also possesses additional restrictions in the form of the prohibited transaction rules.]
(5) Application of the Procedures: Principal Trading.
Principal trading is expressly permitted in limited circumstances under Section 206(3) of the Investment Advisers Act of 1940. However, under the express language of the statute, principal trades can only occur with full disclosure to the client in writing before the completion of the transaction of the capacity in which the investment adviser is acting and obtaining the consent of the client to such transaction.The “ultimate goal” of Section 206(3) is to “prevent trades which are disadvantageous to clients of fiduciary advisors.”
C. THE DUTY TO AVOID UNREASONABLE COMPENSATION.
A fiduciary must not receive unreasonable compensation.
D. ADDITIONAL FIDUCIARY DUTIES.
“A comprehensive list of an adviser’s fiduciary duties is not found in either the common law or the Advisers Act. However, duties of care and loyalty are among the basic fiduciary duties advisers are generally held to owe their clients, at a minimum.
Some authorities also list a duty of obedience.
Still others refer to a duty to act in good faith.
Other authorities cite to a duty of disclosure.
1. Duty of Confidentiality.
The Restatement (Third) of Agency §8.05(2) states that an agent has a duty “not to use or communicate confidential information of the principal for the agent’s own purposes or those of a third party.” While some legal commentators regard the duty of confidentiality as a separate duty, others believe it to be a subset of the duties of due care and loyalty.
2. Is There a Fiduciary Duty to Disclose (Absent a Conflict of Interest?)
Does there exist, under the state common law applying fiduciary principles, a general duty “to disclose” material facts? Generally, no. Rather, the disclosure of material facts is seen as an element of the defense of the fiduciary when a conflict of interest exists. In other words, where a conflict of interest exists, a duty of disclosure of that conflict of interest arises, along with other duties – including the need to undertake such disclosure thoroughly and affirmatively, and the necessity of obtaining the client’s informed consent.
However, Sect. 206(3) of the Advisers Act does impose an obligation of disclosure when investment advisers enter into principal trades with their clients. But, even then, a broad obligation of disclosure is not expressly set forth in the Advisers Act.
Notwithstanding the foregoing, the Commission has implemented a wide variety of specific disclosure obligations, even in situations where no conflict of interest exists. For example, inseeking to meet its duty of loyalty, the Commission has opined that an investment adviser must make full and fair disclosure to its clients of all material facts relating to the advisory relationship.
Full and fair disclosure of all material facts that could affect an advisory relationship, including all material conflicts of interest between the adviser and the client, can help clients and prospective clients in evaluating and selecting investment advisers. Accordingly, the SEC requires advisers to deliver to their clients a “brochure,” under Part 2A of Form ADV, which sets out minimum disclosure requirements, including disclosure of certain conflicts.Investment advisers are required to deliver the brochure to a prospective client at or before entering into a contract so that the prospective client can use the information contained in the brochure to decide whether or not to enter into the advisory relationship.
In other words, a breach of fiduciary obligation — either the obligation not to be in a position of conflict of interest and duty or the obligation not to make unauthorised profits—may be averted or cured by the consent of the principal to whom the obligation is owed, and the principal’s consent will be effective only if the fiduciary has first disclosed to the principal any relevant material information. Rather than constituting the discharge of a fiduciary obligation, disclosure which leads to informed consent confers on a fiduciary immunity from liability for the consequences of actions that would ordinarily amount to breaches of fiduciary obligation. And the immunity-conferring function of disclosure and informed consent provides a complete explanation of the role of disclosure in fiduciary law.”
Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11, 17 (1979) (“Transamerica Mortgage v. Lewis”) (“§ 206 establishes federal fiduciary standards to govern the conduct of investment advisers.”) (quotation marks omitted); Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 471, n.11 (1977) (in discussing SEC v. Capital Gains, stating that the Supreme Court’s reference to fraud in the “equitable” sense of the term was “premised on its recognition that Congress intended the Investment Advisers Act to establish federal fiduciary standards for investment advisers”); SEC v. Capital Gains, supranote 2; Amendments to Form ADV, Investment Advisers Act Release No. 3060 (July 28, 2010) (“Investment Advisers Act Release 3060”) (“Under the Advisers Act, an adviser is a fiduciary whose duty is to serve the best interests of its clients, which includes an obligation not to subrogate clients’ interests to its own,” citing Proxy Voting by Investment Advisers, Investment Advisers Act Release No. 2106 (Jan. 31, 2003) (“Investment Advisers Act Release 2106”)).
See SEC v. Capital Gains, supranote 2 (discussing the history of the Advisers Act, and how equitable principles influenced the common law of fraud and changed the suits brought against a fiduciary, “which Congress recognized the investment adviser to be”).
See SEC v. Capital Gains (“The Advisers Act thus reflects a congressional recognition ‘of the delicate fiduciary nature of an investment advisory relationship,’ as well as a congressional intent to eliminate, or at least to expose, all conflicts of interest which might incline an investment adviser -- consciously or unconsciously -- to render advice which was not disinterested.” and also noting that the “declaration of policy” in the original bill, which became the Advisers Act, declared that “the national public interest and the interest of investors are adversely affected when the business of investment advisers is so conducted as to defraud or mislead investors, or to enable such advisers to relieve themselves of their fiduciary obligations to their clients. It [sic] is hereby declared that the policy and purposes of this title, in accordance with which the provisions of this title shall be interpreted, are to mitigate and, so far as is presently practicable to eliminate the abuses enumerated in this section” (citing S. 3580, 76th Cong., 3d Sess., § 202 and Investment Trusts and Investment Companies, Report of the Securities and Exchange Commission, Pursuant to Section 30 of the Public Utility Holding Company Act of 1935, on Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services, H.R. Doc. No. 477, 76th Cong. 2d Sess., 1, at 28). See also In the Matter of Arleen W. Hughes, Exchange Act Release No. 4048 (Feb. 18, 1948) (“Arleen Hughes”) (discussing the relationship of trust and confidence between the client and a dual registrant and stating that the registrant was a fiduciary and subject to liability under the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act).
U.S. courts have in large part adopted the view of fiduciary obligations as resting upon “the triads of their fiduciary duty—good faith, loyalty or due care.” SeeIn re Alh Holdings LLC, 675 F.Supp.2d 462, 477 (D. Del., 2009). In the context of corporate directors’ fiduciary duties, dictum in Cede & Co. v. Technicolor, Inc., the Delaware Supreme Court announced for the first time that corporate directors owe a “triad” of fiduciary duties, including not only the traditional duties of loyalty and care, but a third duty of “good faith.” 634 A.2d 345, 361 (Del. 1993) (emphasis omitted). See, e.g.,Melvin A. Eisenberg, The Duty of Good Faith in Corporate Law, 31 Del. J. Corp. L. 1, 11 (2006) (“In short, the duty of good faith has long been both explicit and implicit in corporation statutes and implicit in case law. Recently, it has become explicit in case law as well.”); Hillary A. Sale, Delaware’s Good Faith, 89 Cornell L. Rev. 456, 494 (2004) (advocating the need for “a separate good faith duty” to address “those outrageous and egregious abdications of fiduciary behavior that are not simply the results of bad process or conflicts”).
But not all scholars believe that a separate duty of utmost good faith exists. See, e.g., Christopher M. Bruner, Good Faith, State of Mind, and the Outer Boundaries of Director Liability in Corporate Law, 41 Wake Forest L. Rev. 1131 (2006); Andrew S. Gold, The New Concept of Loyalty in Corporate Law, 43 U.C. Davis L. Rev. 457 (2009); Andrew C.W. Lund, Opting Out of Good Faith, 37 Fla. St. U. L. Rev. ___ (2010)
However, often the duty of “utmost good faith” is merged into the other two duties. For example, in the context of fiduciary duties arising for certain actors in corporations, one court explained: “A failure to act in good faith may be shown, for instance, where the fiduciary intentionally acts with a purpose other than that of advancing the best interests of the corporation, where the fiduciary acts with the intent to violate applicable positive law, or where the fiduciary intentionally fails to act in the face of a known duty to act, demonstrating a conscious disregard for his duties. There may be other examples of bad faith yet to be proven or alleged, but these three are the most salient.” Stone ex rel. AmSouth Bancorporation v. Ritter, 911 A.2d 362 (Del. 2006) at text surrounding footnote 26 (footnote omitted). This same court concluded that the duty of good faith is essentially a subset of the duty of loyalty.
Public Comments from Retail Investors and Other Interested Parties on Standards of Conduct for Investment Advisers and Broker-Dealers, Chairman Jay Clayton (June 1, 2017), available at https://www.sec.gov/news/public-statement/statement-chairman-clayton-2017-05-31 (“Chairman Clayton’s Request for Public Input”).
See, e.g.,Comment letter of the Investment Adviser Association (Aug. 31, 2017) (“IAA Letter”) (“The well-established fiduciary duty under the Advisers Act, which incorporates both a duty of loyalty and a duty of care, has been applied consistently over the years by courts and the SEC.”); Comment letter of the Consumer Federation of America (Sept. 14, 2017) (“an adviser’s fiduciary obligation ‘divides neatly into the duty of loyalty and the duty of care.’ The duty of loyalty is designed to protect against ‘malfeasance,’ or wrongdoing, on the part of the adviser, while the duty of care is designed to protect against ‘nonfeasance,’ such as neglect.”).
Investment Advisers Act Release 3060 (adopting amendments to Form ADV and stating that “under the Advisers Act, an adviser is a fiduciary whose duty is to serve the best interests of its clients, which includes an obligation not to subrogate clients’ interests to its own,” citing Investment Advisers Act Release 2106 supra note 10); SEC v. Tambone, 550 F.3d 106, 146 (1st Cir. 2008) (“Section 206 imposes a fiduciary duty on investment advisers to act at all times in the best interest of the fund and its investors.”); SEC v. Moran, 944 F. Supp. 286 (S.D.N.Y 1996) (“Investment advisers are entrusted with the responsibility and duty to act in the best interest of their clients.”). See also In re Prudential Ins. Co. of America Sales Prac., 975 F.Supp. 584, 616 (D.N.J., 1996) (“An essential feature and consequence of a fiduciary relationship is that the fiduciary becomes bound to act in the interests of her beneficiary and not of herself.”)
The suitability standard applicable to broker-dealers has been applied to investment advisers. In 1994, the SEC proposed a rule that would make express the fiduciary obligation of investment advisers to make only suitable recommendations to a client. Investment Advisers Act Release 1406. Although never adopted, the rule was designed, among other things, to reflect the Commission’s interpretation of an adviser’s existing suitability obligation under the Advisers Act. The SEC has stated its belief that this obligation, when combined with an adviser’s fiduciary duty to act in the best interest of its client, requires an adviser to provide investment advice that is suitable for and applying the requisite level of expertise, due diligence and skill.
However, by no means is suitability the standard by which an investment adviser’s due care should be judged. Suitability remains only a small part of an investment adviser’s fiduciary obligation of due care. As the SEC has previously stated, investment advisers owe their clients the duty to provide suitable investment advice. SeeSEC's "Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act" (Jan. 21, 2011), pp.27-8 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.),quotingSuitability of Investment Advice Provided by Investment Advisers, Investment Advisers Act Release No. 1406 (Mar. 16, 1994) (proposing a rule under the Advisers Act Section 206(4)'s antifraud provisions that would expressly require advisers to give clients only suitable advice; the rule would have codified existing suitability obligations of advisers). However, the due diligence burdens on an investment adviser under the duty of due care extend much further than the duties imposed under the suitability standard.
Most individual investors don’t know the fees and costs associated with their investments. For example, a 2004 survey by AARP found that “more than 80 percent of defined contribution pension participants would be categorized as self-reporting that they did not know how much they were paying in fees.”[23]
However, the impact of fees and costs should not be overlooked, and should be considered a primary factor in choosing pooled investment vehicles, with a stronger weight afforded to this factor than other factors. Many have observed that fees and costs in pooled investment vehicles are the most important factor in determining future returns. See, e.g.,Russel Kinnel, Fund Fees Predict Future Success or Failure, Morningstar (May 5, 2016) (“If you've been following Morningstar's research for long, you know how important we think expense ratios are to the fund selection equation. The expense ratio is the most proven predictor of future fund returns. We find that it is a dependable predictor when we run the data. That's also what academics, fund companies, and, of course, Jack Bogle, find when they run the data.”)
Investment advisers should exercise a high degree of caution in utilizing past performance as a substantial factor in their selection, where the investment product possesses higher fees and costs. For example, it may be asked whether higher fees are justified when past returns (adjusting for style differences) of a selected fund are superior. Substantial academic evidence reveals that past performance is seldom, alone, a predictor of future long-term results for stock mutual funds. As one recent academic paper asserts, “more than half of the best funds are simply lucky … [and] only a tiny fraction of 2.1% of all funds yield truly positive alphas.” L. Barras, O. Scaillet, and R. Wermers, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” (2006).
The standard of prudence is relational, and it follows that the standard of care for investment advisers is the standard of a prudent investment adviser. By way of explanation, the standard of care for professionals is that of prudent professionals; for amateurs, it is the standard of prudent amateurs. For example, Restatement of Trusts 2d § 174 (1959) provides: "The trustee is under a duty to the beneficiary in administering the trust to exercise such care and skill as a man of ordinary prudence would exercise in dealing with his own property; and if the trustee has or procures his appointment as trustee by representing that he has greater skill than that of a man of ordinary prudence, he is under a duty to exercise such skill." Case law strongly supports the concept of the higher standard of care for the trustee representing itself to be expert or professional. SeeAnnot., “Standard of Care Required of Trustee Representing Itself to Have Expert Knowledge or Skill”, 91 A.L.R. 3d 904 (1979) & 1992 Supp. at 48-49.
See SEC v. Capital Gains(describing advisers’ “basic function” as “furnishing to clients on a personal basis competent, unbiased, and continuous advice regarding the sound management of their investments” (quoting Investment Trusts and Investment Companies, Report of the Securities and Exchange Commission, Pursuant to Section 30 of the Public Utility Holding Company Act of 1935, on Investment Counsel, Investment Management, Investment Supervisory, and Investment Advisory Services, H.R. Doc. No. 477, 76th Cong. 2d Sess., 1, at 28)). Cf.Barbara Black, Brokers and Advisers-What’s in a Name?, 32 Fordham Journal of Corporate and Financial Law XI (2005) (“[W]here the investment adviser’s duties include management of the account, [the adviser] is under an obligation to monitor the performance of the account and to make appropriate changes in the portfolio.”); Arthur B. Laby, Fiduciary Obligations of Broker-Dealers and Investment Advisers, 55 Villanova Law Review 701, at 728 (2010) (“Laby Villanova Article”) (“If an adviser has agreed to provide continuous supervisory services, the scope of the adviser’s fiduciary duty entails a continuous, ongoing duty to supervise the client’s account, regardless of whether any trading occurs. This feature of the adviser’s duty, even in a non-discretionary account, contrasts sharply with the duty of a broker administering a non-discretionary account, where no duty to monitor is required.”) (internal citations omitted).
In the Matter of Dawson-Samberg Capital Management, Inc., now known as Dawson-Giammalva Capital Management, Inc. and Judith A. Mack, Advisers Act Release No. 1889 (August 3, 2000), citing SEC v.Capital Gains Research Bureau, 375 U.S. at 191-92.
SeeCommission Guidance Regarding the Duties and Responsibilities of Investment Company Boards of Directors with Respect to Investment Adviser Portfolio Trading Practices, Release Nos. 34-58264; IC-28345 (July 30, 2008), at 23: “Second, investment advisers, as fiduciaries, generally are prohibited from receiving any benefit from the use of fund assets ….”
While this statement may appear harsh to some commentators, it is reflective of the vast disparity of knowledge and expertise between the investment adviser and the client, and also reflects the important public policy reasons that support the imposition of the fiduciary standard upon investment advisers. The investment adviser-client relationship is closely analogous to the attorney-client relationship.See, e.g.,Julia Smith, Out with “TCF” and in with “fiduciary”?, Butterworths Journal of International Banking and Financial Law (June 2012), P.344 [U.K.] [“On 23 February 2012, the FSCP proposed an amendment to the Financial Services Bill because: “Customers of banks should be owed the same fiduciary duty as those seeking the advice of a lawyer or an MP, with providers prohibited from profiting from conflicts of interest at the expense of their customers…The new Financial Conduct Authority (FCA) should be given powers to make rules to ensure that the industry would have to take their customers’ interests into account when designing products and providing advice.”]
In the Matter of Dawson-Samberg Capital Management, Inc., now known as Dawson-Giammalva Capital Management, Inc. and Judith A. Mack, Advisers Act Release No. 1889 (August 3, 2000), citing SEC v.Capital Gains Research Bureau, 375 U.S. at 191-92.
“When a conflict exists for fiduciaries of a retirement plan that is governed by ERISA, two distinct sets of ERISA requirements are implicated: (1) the rules governing breaches of fiduciary duty found in ERISA §404(a) and (2) the prohibited transaction rules in ERISA §§406(a) and (b) … Fiduciaries are obligated under ERISA’s fiduciary responsibility rules to (1) identify conflicts (or potential conflicts) that may impact the management of a plan; (2) evaluate those conflicts and the impact they may have on the plan and its participants; (3) determine whether the conflicts will adversely impact the plan; (4) consider protections that would protect the plan and participants from any potential adverse effect of the conflict (for instance, appointing an independent fiduciary to evaluate the investment or proposed service provider) and; (5) if the conflict adversely impacts the plan and its participants, change service providers, investments or other circumstances related to the conflict.
Although a conflict of interest may exist in connection with a proposed transaction, entering into the transaction may or may not be a breach of fiduciary duty – the determining factors are whether the fiduciary prudently evaluates the conflict, and acts solely in the interest of the participants and for the exclusive purpose of providing benefits. If material adverse impact on the participants cannot be avoided or properly mitigated, entering into the transaction would not be prudent and would trigger a fiduciary breach.
Furthermore, if a conflict of interest is precluded under ERISA's prohibited transaction rules, the fiduciaries cannot, as a matter of law, allow the plan to become a party to the transaction – even if the action were otherwise reasonable or profitable to the plan.” C. Frederick Reish And C. Faucher, The Fiduciary Duty to Avoid Conflicts of Interest in Selecting Plan Service Providers (April 2009), available at http://www.reish.com/publications/pdf/whitepprmar09.pdf.
“Avoidance is perhaps the best solution to conflict situations. Persons having a duty to exercise judgment in the interest of another must avoid situations in which their interests pose an actual or potential threat to the reliability of their judgment. Although avoidance of conflict situations is an important duty of decision-makers, a flat prescription to avoid all conflicts of interest is not only mistaken, but also unworkable. On the one hand, not all conflicts of interest are avoidable. Some conflict situations are embedded in the relation, while others occur independently of decision-maker’s will.” Fiduciary Duties and Conflicts of Interest: An Inter-Disciplinary Approach (2005), at p.20, available at http://eale.org/content/uploads/2015/08/fiduciary-duties-and-conflicts-of-interestaugust05.pdf.
“The federal securities laws and FINRA rules restrict broker-dealers from participating in certain transactions that may present particularly acute potential conflicts of interest. For example, FINRA rules generally prohibit a member with certain ‘conflicts of interest’ from participating in a public offering, unless certain requirements are met. FINRA members also may not provide gifts or gratuities to an employee of another person to influence the award of the employer’s securities business. FINRA rules also generally prohibit a member’s registered representatives from borrowing money from or lending money to any customer, unless the firm has written procedures allowing such borrowing or lending arrangements and certain other conditions are met. Moreover, the Commission’s Regulation M generally precludes persons having an interest in an offering (such as an underwriter or broker-dealer and other distribution participants) from engaging in specified market activities during a securities distribution. These rules are intended to prevent such persons from artificially influencing or manipulating the market price for the offered security in order to facilitate a distribution.” SEC’s “Staff Study on Investment Advisers and Broker-Dealers - As Required by Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act” (Jan. 21, 2011), pp.58-9 (available at http://sec.gov/news/studies/2011/913studyfinal.pdf.) (Citations omitted.) “FINRA rules also establish restrictions on the use of non-cash compensation in connection with the sale and distribution of mutual funds, variable annuities, direct participation program securities, public offerings of debt and equity securities, and real estate investment trust programs. These rules generally limit the manner in which members can pay for or accept non-cash compensation and detail the types of non-cash compensation that are permissible.” Id.at p.68.
Tuch, Andrew, “The Paradox of Financial Services Regulation: Preserving Client Expectations of Loyalty in an Industry Rife with Conflicts of Interest” (January 2008) (Australia) (noting “When an investment bank performs one of its traditional functions – underwriting securities offerings or providing financial advisory services to clients involved in mergers, acquisitions and other strategic transactions – it may under general law be a fiduciary of its client and thereby be required to avoid positions of conflict without its client’s informed consent. Yet the conglomerate structure of the firm may make conflicts of interest an inescapable feature of its doing business.”
Delivery of the investment advisers Part 2 of Form ADV may not result in timely disclosure, especially when the transaction occurs days, weeks, or months after the transaction is proposed to the client. “The adviser’s fiduciary duty of disclosure is a broad one, and delivery of the adviser’s brochure alone may not fully satisfy the adviser’s disclosure obligations.” SEC Staff Study (Jan. 2011), p.23, citingsee Instruction 3 of General Instructions for Part 2 of Form ADV; Advisers Act Rule 204-3(f); also citing see alsoRelease IA-3060. Note, as well, that the investment adviser must ensure client understanding; a client should not be presumed to have read and understood the disclosures contained in Part 2 of Form ADV.
The disclosure must be affirmatively made (the “duty of inquiry” and the “duty to read” are limited in fiduciary relationships) and must be timely made – i.e., in advance of the contemplated transaction. [“Where a fiduciary relationship exists, facts which ordinarily require investigation may not incite suspicion (see, e.g., Bennett v. Hibernia Bank,164 Cal.App.3d 202, 47 Cal.2d 540, 560, 305 P.2d 20 (1956), and do not give rise to a duty of inquiry (id., at p. 563, 305 P.2d 20). Where there is a fiduciary relationship, the usual duty of diligence to discover facts does not exist. United States Liab. Ins. Co. v. Haidinger-Hayes, Inc., 1 Cal.3d 586, 598, 83 Cal.Rptr. 418, 463 P.2d 770 (1970), Hobbs v. Bateman Eichler, Hill Richards, Inc., 210 Cal.Rptr. 387, 164 Cal.App.3d 174 (Cal. App. 2 Dist., 1974).)
The burden of affirmative disclosure rests with the professional advisor; constructive notice is insufficient. See also British Airways, PLC v. Port Authority of N.Y. and N.J., 862 F.Supp. 889, 900 (E.D.N.Y.1994) (stating that the burden is on the client's attorney to fully inform and obtain consent from the client); Kabi Pharmacia AB v. Alcon Surgical, Inc., 803 F.Supp. 957, 963 (D.Del.1992) (stating that evidence of the client's constructive knowledge of a conflict would not be sufficient to satisfy the attorney's consultation duty); Manoir-Electroalloys Corp. v. Amalloy Corp., 711 F.Supp. 188, 195 (D.N.J.1989) ("Constructive notice of the pertinent facts is not sufficient."). A client of a fiduciary is not responsible for recognizing the conflict and stating his or her lack of consent in order to avoid waiver. Manoir-Electroalloys, 711 F.Supp. at 195.
SeeGeneral Instruction 3 to Part 2 of Form ADV. Cf. Arleen Hughes, supra note 13 (Hughes acted simultaneously in the dual capacity of investment adviser and of broker and dealer and conceded having a fiduciary duty. In describing the fiduciary duty and her potential liability under the antifraud provisions of the Securities Act and the Exchange Act, the Commission stated she had “an affirmative obligation to disclose all material facts to her clients in a manner which is clear enough so that a client is fully apprised of the facts and is in a position to give his informed consent.”
The extent of the disclosure required is made clear by cases applying the fiduciary standard of conduct in related professional advisory contexts, such as the duties imposed upon an attorney with respect to his or her client: “The fact that the client knows of a conflict is not enough to satisfy the attorney's duty of full disclosure.”In re Src Holding Corp., 364 B.R. 1 (D. Minn., 2007). "Consent can only come after consultation — which the rule contemplates as full disclosure.... [I]t is not sufficient that both parties be informed of the fact that the lawyer is undertaking to represent both of them, but he must explain to them the nature of the conflict of interest in such detail so that they can understand the reasons why it may be desirable for each to [withhold consent].")Florida Ins. Guar. Ass'n Inc. v. Carey Canada, Inc., 749 F.Supp. 255, 259 (S.D.Fla.1990) [emphasis added],quoting Unified Sewerage Agency, Etc. v. Jeko, Inc., 646 F.2d 1339, 1345-46 (9th Cir.1981)); “[t]he lawyer bears the duty to recognize the legal significance of his or her actions in entering a conflicted situation and fully share that legal significance with clients.” In re Src Holding Corp., 364 B.R. 1, 48 (D. Minn., 2007) [emphasis added].
Wendt v. Fischer, 243 N.Y. 439, 154 N.E. 303 (1926). See also“Will the Investment Company and Investment Advisory Industry Win an Academy Award?” remarks of Kathryn B. McGrath, then-Director of the SEC Division of Investment Management, at the 1987 Mutual Funds and Investment Management Conference, citingScott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949). See alsoBogert on Trusts, Paul D. Finn, Fiduciary Obligations(1977); J.C. Shepherd, The Law of Fiduciaries(1981). See also Scott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949).
Even in arms-length relationships, a ratification or waiver defense may fail if the customer proves that he did not have all the material facts relating to the trade at issue. E.g., Davis v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 906 F.2d 1206, 1213 (8th Cir. 1990); Huppman v. Tighe, 100 Md. App. 655, 642 A.2d 309, 314-315 (1994). In contrast, in fiduciary relationships the failure to disclose material facts while seeking a release has been held to be actionable, as fraudulent concealment. See, e.g., Pacelli Bros. Transp. v. Pacelli, 456 A.2d 325, 328 (Conn. 1982) (‘the intentional withholding of information for the purpose of inducing action has been regarded ... as equivalent to a fraudulent misrepresentation.’); Rosebud Sioux Tribe v. Strain, 432 N.W. 2d 259, 263 (S.D. 1988) (‘The mere silence by one under such a [fiduciary] duty to disclose is fraudulent concealment.’)” (Id.)
The Commission has stated that disclosure must occur not only of conflicts of interest, but also of potential conflicts of interest. See Release No. IA-1396, In the Matter of: Kingsley, Jennison, Mcnulty & Morse Inc. (Dec. 23, 1993).
As stated in an early decision by the U.S. Securities and Exchange Commission: “[We] may point out that no hard and fast rule can be set down as to an appropriate method for registrant to disclose the fact that she proposes to deal on her own account. The method and extent of disclosure depends upon the particular client involved. The investor who is not familiar with the practices of the securities business requires a more extensive explanation than the informed investor. The explanation must be such, however, that the particular client is clearly advised andunderstandsbefore the completion of each transaction that registrant proposes to sell her own securities.” [Emphasis added.] In re the Matter of Arleen Hughes, SEC Release No. 4048 (1948).
“[D]isclosure is an effective response if it does not affect the decision-maker’s judgment process and if the beneficiary is able to correct adequately for that biasing influence. Psychological research shows that neither of these conditions may be met. Sometimes both parties may be worse off following disclosure.” Id., citingDaylian M. Cain, George Loewenstein, and Don A. Moore, “The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest” (2005) 34 Journal of Legal Studies 1 at 3.
An “irreducible core” of fiduciary duties exist, which are not subject to waiver by disclosure and consent under any circumstances. SeeA. Trukhtanov, The Irreducible Core of Fiduciary Duties (2007) 123 LQR 342.
Comment letter of Mercer Bullard, Founder and President, Fund Democracy, and Barbara Roper, Director of Investor
Protection, Consumer Federation of America, Nov. 30, 2007, available at http://sec.gov/comments/s7-23-07/s72307-18.pdf, at
Geman v. S.E.C., 334 F.3d 1183, 1189 (10th Cir., 2003), quoting Arst v. Stifel, Nicolaus & Co., 86 F.3d 973, 979 (10th Cir.1996) (applying Kansas law) (quotingRestatement (Second) Of Agency§ 390 cmt. a (1958)).
See, e.g., “Will the Investment Company and Investment Advisory Industry Win an Academy Award?” remarks of Kathryn B. McGrath, Director of the SEC Division of Investment Management, at the 1987 Mutual Funds and Investment Management Conference (“McGrath Remarks”), citingScott, The Fiduciary Principle, 37 Calif. L. Rev. 539, 544 (1949), at p.7: “The words ‘fiduciary duty’ refer to the duties, of first, obedience to the terms of one's trust, second, diligence and care in the carrying out of one's fiduciary functions, and third, undivided loyalty to the beneficiaries of one's trust.” Other authorities do not list the duty of obedience separately, but rather consider it within the framework of the other basic duties of care and loyalty.” Lorna A. Schnase, An Investment Adviser’s Fiduciary Duty (Aug. 1, 2010), at p.5, available at http://www.40actlawyer.com/Articles/Link3-Adviser-Fiduciary-Duty-Paper.pdf.
Investment Advisers Act rule 204-3. Investment Advisers Act Release 3060 (adopting amendments to Form ADV and stating that “A client may use this disclosure to select his or her own adviser and evaluate the adviser’s business practices and conflicts on an ongoing basis. As a result, the disclosure clients and prospective clients receive is critical to their ability to make an informed decision about whether to engage an adviser and, having engaged the adviser, to manage that relationship.”).
Ron A. Rhoades, J.D., CFP® is an Asst. Professor of Finance at Western Kentucky University's Gordon Ford College of Business, where he serves as Director of its nationally recognized Personal Financial Planning program. This article represents his views, alone, and are not those of any institution, organization or firm with whom he may be associated. Follow Ron on Twitter: @280lmtd. To contact him, please email: Ron.Rhoades@wku.edu.
